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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES

ESAs 2016 23

08 03 2016

Final Draft Regulatory Technical Standards

on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012

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Contents

1. Executive Summary 3

2. Background and rationale 5

3. Draft regulatory technical standards on risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty under Article 11(15) of Regulation (EU) No 648/2012 15

4. Accompanying documents 65

4.1 Draft cost-benefit analysis 65 4.2 Feedback on the public consultation 95

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1. Executive Summary

The European Supervisory Authorities (ESAs) have been mandated to develop common draft regulatory technical standards (RTS) that outline the concrete details of the regulatory framework which implements Article 11 of Regulation (EU) No 648/2012 (EMIR) 1. The EMIR introduces a requirement to exchange margins on non-centrally cleared OTC derivatives. Specifically, the EMIR delegates powers to the Commission to adopt RTS specifying:

1. the risk-management procedures for non-centrally cleared OTC derivatives;

2. the procedures for counterparties and competent authorities concerning intragroup exemptions for this type of contract; and

3. the criteria for the identification of practical or legal impediment to the prompt transfer of funds between counterparties.

The EMIR mandates the ESAs to develop standards that set out the levels and type of collateral and segregation arrangements required to ensure the timely, accurate and appropriately segregated exchange of collateral. This will include margin models, the eligibility of collateral to be used for margins, operational processes and risk-management procedures. In developing these standards, the ESAs have taken into consideration the need for international consistency and have consequently used the BCBS-IOSCO framework as the natural starting point. In addition, a number of specific issues have been clarified so that the proposed rules will implement the BCBS-IOSCO framework while taking into account the specific characteristics of the European financial market.

The second consultation paper, published on June 20152, built on the proposals outlined in the ESAs first consultation paper3. The ESAs, after reviewing all the responses to the first consultation paper, engaged in intensive dialogues with other authorities and industry stakeholders in order to identify all the operational issues that may arise from the implementation of this framework.

These draft RTS prescribe the regulatory amount of initial and variation margins to be posted and collected and the methodologies by which that minimum amount should be calculated. Under both approaches, variation margins are to be collected to cover the mark-to-market exposure of the OTC derivative contracts. Initial margin covers the potential future exposure, and counterparties can choose between a standard pre-defined approach based on the notional value of the contracts and an internal modelling approach, where the initial margin is determined based on the modelling of the exposures. This allows counterparties to decide on the complexity of the models to be used.

1 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories. 2 Second Joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP (EBA/JC/CP/2015/002). 3 Joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP (JC/CP/2014/03), issued by the EBA, EIOPA and ESMA on 14 April 2014.

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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES The draft RTS also outline the collateral eligible for the exchange of margins. The list of eligible collateral covers a broad set of securities, such as sovereign securities, covered bonds, specific securitisations, corporate bonds, gold and equities. In addition, the RTS establish criteria to ensure that collateral is sufficiently diversified and not subject to wrong-way risk. Finally, to reflect the potential market and foreign exchange volatility of the collateral, the draft RTS prescribe the methods for determining appropriate collateral haircuts.

Significant consideration has also been given to the operational procedures that have to be established by the counterparties. Appropriate risk-management procedures should include specific operational procedures. The draft RTS provide the option of applying an operational minimum transfer amount of up EUR 500 000 when exchanging collateral.

With regard to intragroup transactions, a clear procedure is established for the granting of intragroup exemptions allowed under the EMIR. This procedure will harmonise the introduction of such procedures and provide clarity on these aspects.

The draft RTS also acknowledge that a specific treatment of certain products may be appropriate. This includes, for instance, physically settled FX swaps, which may not be subject to initial margin requirements.

Furthermore, to allow counterparties time to phase in the requirements, the standard will be applied in a proportionate manner. Therefore, the requirements for the initial margin will, at the outset, apply only to the largest counterparties until all counterparties with notional amounts of non-centrally cleared derivatives in excess of EUR 8 billion are subject to the rules, as from 2020. The scope of application for counterparties subject to initial margin requirements is therefore clearly specified.

Quantitative and qualitative aspects concerning the costs and benefits of the proposed rules are discussed in the annex. The annex supplements the proposal and illustrates the reasoning behind the policy choices made.

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2. Background and rationale

The EMIR establishes provisions aimed at increasing the safety and transparency of the over-the-counter (OTC) derivative markets. Among other requirements, it introduces a legal obligation to clear certain types of OTC derivatives through central counterparties (CCPs). However, not all OTC derivative contracts will be subject to the clearing obligation or would meet the conditions to be centrally cleared. In the absence of clearing by a CCP, it is essential that counterparties apply robust risk-mitigation techniques to their bilateral relationships to reduce counterparty credit risk. This will also mitigate the potential systemic risk that can arise in this regard.

Therefore, Article 11 of the EMIR requires the use of risk-mitigation techniques for transactions that are not centrally cleared and, in paragraph 15, mandates the ESAs to develop RTS on three main topics: (1) the risk-management procedures for the timely, accurate and appropriately segregated exchange of collateral; (2) the procedures concerning intragroup exemptions; and (3) the criteria for the identification of practical or legal impediment to the prompt transfer of funds between counterparties belonging to the same group.

The ESAs consulted twice on this set of RTS, in 2014 and 2015. The ESAs also engaged in intensive dialogues with other authorities and industry stakeholders in order to identify all the operational issues that may arise from the implementation of this framework.

To avoid regulatory arbitrage and to ensure a harmonised implementation at both the EU level and globally, it is crucial for individual jurisdictions to implement rules consistent with international standards. Therefore, these draft RTS are aligned with the margin framework for non-centrally cleared OTC derivatives issued by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) on September 20134. The international standards outline the final margin requirements, which the ESAs have endeavoured to transpose into the RTS.

The overall reduction of systemic risk and the promotion of central clearing are identified as the main benefits of this framework. To achieve these objectives, the BCBS-IOSCO framework set out eight key principles and a number of detailed requirements. It is the opinion of the ESAs that this regulation is in line with the principles of that framework.

These draft RTS are divided into three main parts: the introductory remarks, a draft of the RTS and the accompanying material, including a cost-benefit analysis and an impact assessment. The draft RTS document is further split into chapters in line with the mandate. A number of topics are covered in the first chapter, such as general counterparties risk-management procedures, margin methods, eligibility and treatment of collateral, operational procedures and documentation.

4 Margin requirements for non-centrally cleared derivatives final document, issued by BCBS and IOSCO on March 2015.

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http://www.bis.org/bcbs/publ/d317.htm

RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES The last two chapters cover the procedures for counterparties and competent authorities concerning the exemption of intragroup OTC derivative contracts.

The sections below describe in greater detail the content of these draft RTS.

Counterparties risk-management procedures required for compliance with Article 11(3) of the EMIR

The first part of these draft RTS outlines the scope of the application of these requirements by identifying the counterparties and transactions subject to the following provisions. The EMIR requires financial counterparties to have risk-management procedures in place that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts. Non-financial institutions must have similar procedures in place, if they are above the clearing threshold. Consistent with this goal, to prevent the build-up of uncollateralised exposures within the system, the RTS require the daily exchange of variation margin with respect to transactions between such counterparties.

Subject to the provisions of the RTS, the entities mentioned above, i.e. financial and certain non-financial counterparties, will also be required to exchange two-way initial margin to cover the potential future exposure resulting from a counterparty default. To act as an effective risk mitigant, initial margin calculations should reflect changes in both the risk positions and market conditions. Consequently, counterparties will be required to calculate and collect variation margin daily and to calculate initial margin at least when the portfolio between the two entities or the underlying risk measurement approach has changed. In addition, to ensure current market conditions are fully captured, initial margin is subject to a minimum recalculation period.

In order to align with international standards, the requirements of the RTS will apply only to transactions between identified OTC derivative market participants. The provisions of the RTS on initial margin will therefore apply to entities that have an OTC derivative exposure above a predetermined threshold, defined in the draft RTS as above EUR 8 billion in gross notional outstanding amount. This reduces the burden on smaller market participants, while still achieving the margin frameworks principle objective of a sizable reduction in systemic risk. These draft RTS impose an obligation on EU entities to collect margins in accordance with the prescribed procedures, regardless of whether they are facing EU or non-EU entities. Given that non-financial entities established in a third country that would be below the clearing threshold if established in the Union would have the same risk profile as non-financial counterparties below the clearing threshold established in the Union, the same approach should be applied to them in order to prevent regulatory arbitrage.

The RTS recognise that the exchange of collateral for only minor movements in valuation might lead to an overly onerous exchange of collateral and that initial margin requirements will have a measurable impact. Therefore, the RTS include a threshold to limit the operational burden and a threshold for managing the liquidity impact associated with initial margin requirements. Both thresholds are fully consistent with international standards.

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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES The first threshold ensures that the exchange of initial margins does not need to take place if a counterparty has no significant exposures to another counterparty. Specifically, it may be agreed bilaterally to introduce a threshold of up to EUR 50 million, which will ensure that only counterparties with significant exposures will be subject to the initial margin requirements.

The second threshold (minimum transfer amount) ensures that, when market valuations fluctuate, new contracts are drawn up or other aspects of the covered transactions change; an exchange of collateral is only necessary if the change in the initial and variation margin requirements exceeds EUR 500 000. Similarly to the first threshold, counterparties may agree on the introduction of a threshold in their bilateral agreement as long as the minimum exchange threshold does not exceed EUR 500 000. Therefore, the exchange of collateral only needs to take place when recalculated changes to the margin requirements are above the agreed thresholds, to limit the operational burden relating to these requirements.

In the first consultation paper, the draft RTS were developed on the basis that counterparties in the scope of the margin requirements are required to collect margins. As two counterparties that are subject to EU regulation are both obliged to collect collateral, this would imply an exchange of initial margins. The underlying assumption was also that counterparties in equivalent third country jurisdictions would also be required to collect, so Union counterparties trading with third country counterparties were expected to post and collect initial and variation margins. Respondents to the first consultation and third country authorities highlighted that this would not always be the case, as some entities might be not covered by margin rules in a third country jurisdiction. In the final draft RTS counterparties are required not only to collect but also to post margins. This approach ensures that Union counterparties are not put at a competitive advantage with respect to entities in other major jurisdictions.

For derivative contracts with counterparties domiciled in certain emerging markets, the enforceability of netting agreements or the protection of collateral cannot be supported by an independent legal assessment (non-netting jurisdictions). Where such assessments are negative, counterparties should rely on alternative arrangements such as posting collateral to international custodians. As this is not always a viable solution, these situations should be treated as special cases. The final RTS prescribe that, where possible, a Union counterparty should collect collateral and post it to its counterparty; however, where a jurisdiction lacks proper infrastructures, the Union counterparty should be allowed to only collect collateral without posting any, as this would result in sufficient protection for the counterparty subject to the EMIR. In order to avoid undermining the objectives of the EMIR, OTC derivative contracts that are not covered by margin exchange at all should be strictly limited; this can be achieved by setting a maximum ratio between the total notional amount of OTC derivative contracts with counterparties in non-netting jurisdictions and the total amount at group level.

The group-wide aggregate notional amount determines when counterparties are in the scope of the variation margin requirements and determines when and what counterparties are in the scope of the initial margin requirements. The RTS prescribe that all intragroup OTC derivatives are to be included in the calculation and but should be counted only once. Intragroup derivatives exempted under

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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES Articles 11(5) to (10) of the EMIR should also be included in the calculation. This is in line with the similar treatment of intragroup transactions for the calculation of the aggregated notional amount for the clearing threshold. Furthermore, this approach was chosen to align with prevailing international practices.

The use of cash initial margin is limited: a maximum of 20% of the total collateral collected from a single counterparty can be maintained in cash per single custodian. This requirement applies only to systemically important banks, GSIIs and OSIIs, dealing among themselves. Other counterparties would have no limit on posting or collecting cash IM. The final RTS prescribe that when a counterparty exchange IM in cash the choice of the custodian should be taken into account the custodians credit quality; this is because cash is difficult to be segregated and therefore there is a credit risk toward the custodian itself. The RTS do not set any limit on the exposures or constraints on the credit quality of the custodian itself; in particular, there is no reference to any minimum external rating. Furthermore, the final RTS provide that cash VM should not be subject to a currency mismatch haircut but cash IM should be subject to a currency mismatch haircut, like any other collateral.

Margin calculation

Section 4 of the final RTS outlines the approach that counterparties may use to calculate initial margin requirements: the standardised approach and the initial margin models.

The standardised approach mirrors the mark-to-market method set out in Articles 274 and 298 of Regulation (EU) No 575/2013 (CRR). It is a two-step approach: firstly, derivative notional amounts are multiplied by add-on factors that depend on the asset class and the maturity, resulting in a gross requirement; secondly, the gross requirement is reduced to take into account potential offsetting benefits in the netting set (net-to-gross ratio). Unlike the mark-to-market method, the add-on factors are adjusted to align with those envisaged in the international standards.

Alternatively, counterparties may use initial margin models that comply with the requirements set out in the RTS. Initial margin models can either be developed by the counterparties or be provided by a third-party agent. The models are required to assume the maximum variations in the value of the netting set at a confidence level of 99% with a risk horizon of at least 10 days. Models must be calibrated on a historical period of at least three years, including a period of financial stress; in particular, in order to reduce procyclicality, observations from the period of stress must represent at least 25% of the overall data set. To limit the recognition of diversification benefits, a model can only account for offset benefits for derivative contracts belonging to the same netting set and the same asset class. Additional quantitative requirements are set out to ensure that all relevant risk factors are included in the model and that all basis risks are appropriately captured. Furthermore, the models must be subject to an initial validation, periodical back-tests and regular audit processes. All key assumptions of the model, its limitations and operational details must be appropriately documented.

Cross-border transactions where jurisdictions apply different definitions of OTC derivatives or a different scope of the margin rules are addressed in a separate article. The strict requirements

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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES impose limits on the calculation of margins in a netting set only to non-centrally cleared OTC derivatives that are in the scope of the margin rules in one or the other jurisdiction. This should avoid margin calculations being improperly reduced, for example by including in the calculation other products that are not non-centrally cleared OTC derivatives.

Eligibility and treatment of collateral

The final RTS set out the minimum requirements for collateral to be eligible for the exchange of margins by counterparties and the treatment of collateral, its valuation and the haircuts to be applied.

Even if margin is exchanged in an amount appropriate to protect the counterparties from the default of a derivative counterparty, the counterparties may nevertheless be exposed to loss if the posted collateral cannot be readily liquidated at full value should the counterparty default. This issue may be particularly relevant during periods of financial stress. The RTS provide counterparties with the option of agreeing on the use of more restrictive collateral requirements, i.e. a subset of the eligible collateral as set out in the RTS.

Assets that are deemed to be eligible for margining purposes should be sufficiently liquid, not be exposed to excessive credit, market and FX risk and hold their value in a time of financial stress. Furthermore, with regard to wrong-way risk, the value of the collateral should not exhibit a significant positive correlation with the creditworthiness of the counterparty. The accepted collateral should also be reasonably diversified. To the extent that the value of the collateral is exposed to market and FX risk, risk-sensitive haircuts should be applied. This ensures that the risk of losses in the event of a counterparty default is minimised.

The draft RTS set out a list of eligible collateral, eligibility criteria, requirements for credit assessments and requirements regarding the calculation and application of haircuts. Wrong-way risk and concentration risk are also addressed by specific provisions. Additionally, the RTS require that risk-management procedures include appropriate collateral-management procedures. A set of operational requirements is therefore included to ensure that counterparties have the capabilities to properly record the collected collateral and manage the collateral in the event of the default of the other counterparty.

The ESAs have adopted the key principles outlined in the international standards and have adapted these principles to take into account EU-wide market conditions. This will ensure a harmonised EU implementation of the RTS whilst respecting the conditions of the relevant markets. The ESAs consider it appropriate to allow a broad set of asset classes to be eligible collateral and expect that bilateral agreements will further restrict the eligible collateral in a way that is compatible with the complexity, size and business of the counterparties. As a starting point, the list of eligible collateral is based on the provisions laid down by Articles 197 and 198 of the CRR, relating to financial collateral available under the credit risk mitigation framework of institutions, and includes only funded protection. All asset classes on this list are deemed to be eligible in general for the purposes of the RTS. However, all collateral has to meet additional eligibility criteria such as low credit, market and FX risk.

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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES The ESAs have considered several methodologies to ensure that the collected collateral is of sufficient credit quality. In particular, in accordance with Regulation No 462/2013 on credit rating agencies (CRA 3), the ESAs introduced mitigants against an excessive reliance on external ratings.

Furthermore, the use of either an internal or external credit assessment process remains subject to a minimum level of credit quality. Namely, the RTS allow the use of internal-ratings-based (IRB) approaches by credit institutions authorised under the CRR. The current disclosure requirements are sufficient to allow counterparties the necessary degree of understanding of the methodology. If there is not an approved IRB approach for the collateral or if the two counterparties do not agree on the use of the internal-ratings-based approach developed by one counterparty, the two counterparties can define a list of eligible collateral relying on the external credit assessments of recognised external credit assessment institutions (ECAIs). The minimum level of credit quality is set out with reference to a high Credit Quality Step (CQS) for most collateral types. The use of the CQS must be consistent with the Implementing Technical Standards (ITS) of the ESA on the mapping of credit assessments to risk weights of ECAIs under Article 136 of the CRR.

The risk of introducing cliff effects possibly triggering a market sell-off after a ratings downgrade where counterparties would be required by the regulation to replace collateral has also been addressed in the development of the RTS with the introduction of concentration limits. As the risk of cliff effects may not be sufficiently mitigated by the introduction of internal credit assessments, these draft RTS also allow the minimum level of credit quality set out in the RTS to be exceeded for a grace period following a downgrade. However, this is conditional on the counterparty starting a well-defined process to replace the collateral.

Two requirements are necessary on top of the other provisions on the collateral eligible for the exchange of margins: measures preventing wrong-way risk on the collateral and concentration limits. The RTS do not allow own-issued securities to be eligible collateral, except on sovereign debt securities. However, this requirement extends to corporate bonds, covered bonds, other debt securities issued by institutions and securitisations. These requirements will reduce concentration risk in the collateral placed in margins and are considered necessary to fulfil the requirement to have sufficient high-quality collateral available following the default of a counterparty.

The ESAs considered the peculiar market characteristics of sovereign debt securities and their investors. As many smaller market participants tend to have substantial investments in local sovereign securities and a diversification may increase, instead of reducing, their risk profile, the ESAs are of the opinion that concentration limits for this particular asset class should be required only for systemically important entities. However, the existing identification of systemically important banks (GSIIs and OSIIs) would only be valid for that particular sector. Therefore, the draft RTS include an additional threshold that, referring to the total amount of collected initial margin, aims to identify other major participants in the OTC derivative market that are not banks. For the sake of consistency, the diversification requirements for this asset class only apply to trades between systemically important counterparties and not to trades between them and smaller counterparties.

The collateral requirements set out in the draft RTS strive to strike a good balance between two conflicting objectives. Firstly, there is the need to have a broad pool of eligible collateral that also

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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES avoids an excessive operational and administrative burden on both supervisors and market participants. Secondly, the quality of eligible collateral must be sufficient while limiting cliff effects in the form of introducing reliance on ECAI ratings. However, the risk of losses on the collateral is not only mitigated by ensuring collateral of sufficiently high quality; it is also considered necessary to apply appropriate haircuts to reflect the potential sensitivity of the collateral to market and foreign exchange volatilities. The current draft RTS allow either the use of internal models for the calculation of haircuts or the use of standardised haircuts. Haircut methodologies provide transparency and are designed to limit procyclical effects.

In order to provide a standardised haircut schedule, haircuts in line with the credit risk mitigation framework have been adopted across the different levels of Credit Quality Steps. It should be noted that the international standards provide haircut levels in the standardised method (standard schedule), also derived from the standard supervisory haircuts adopted in the Basel Accords approach to the collateralised transactions framework. However, the standard schedule presented in the international standards only contains haircuts for collateral of very high credit quality with an external credit assessment equivalent to CQS 1. The list of eligible collateral in the draft RTS includes collateral with a lower, albeit still sufficiently high, credit quality. The draft RTS extend the standardised schedule of haircuts based on the credit risk mitigation framework of the CRR.

The section on eligible collateral has been drafted to ensure full alignment with the international standards. It was considered important to take into account the specificities of the European markets, but also to provide a harmonised approach that would ensure consistency of implementation across EU jurisdictions.

Operational procedures

The RTS recognise that the operational aspects relating to the exchange of margin requirements will require substantial effort to implement in a stringent manner. It is therefore necessary for counterparties to implement robust operational procedures that ensure that documentation is in place between counterparties and internally at the counterparty. These requirements are considered necessary to ensure, that the requirements of the RTS are implemented in a careful manner that minimises the operational risk of these processes.

The operational requirements include, among other things, clear senior management reporting, escalation procedures (internally and between counterparties) and requirements to ensure sufficient liquidity of the collateral. Furthermore, counterparties are required to conduct tests on the procedures, at least on an annual basis.

Segregation requirements must be in place to ensure that collateral is available in the event of a counterparty defaulting. In general, operational and legal arrangements must be in place to ensure that the collateral is bankruptcy remote.

The BCBS-IOSCO framework does not generally allow re-use or re-hypothecation of initial margins and restricts re-use to very specific cases. After considering the characteristics of the European market, where re-use and re-hypothecation subject to the restrictions of the international standards

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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES would be of limited use, the ESAs propose that the RTS do not include this possibility. As a special case, the RTS allow a third-party custodian or holder to re-invest initial margin posted in cash as this seems to be common market practice and the use of cash IM is usually disincentivised by the same custodians because of the additional costs related to it.

Procedures concerning intragroup derivative contracts

In accordance with Article 11(6) to 11(10) of the EMIR, intragroup transactions can be exempted from the requirement to exchange collateral if certain requirements regarding risk-management procedures are met and there are no practical or legal impediments to the transferability of own funds and the repayment of liabilities. Depending on the type of counterparties and where they are established, there is either an approval or a notification process.

Without further clarification, there would be a risk that competent authorities would follow very different approaches regarding the approval or notification process. Therefore, these draft RTS specify a number of key elements including the amount of time that competent authorities have to grant an approval or to object, the information to be provided to the applicant and a number of obligations on the counterparties.

To ensure that the criteria for granting an exception are applied consistently across the Member States, the draft RTS further clarify which requirements regarding risk-management procedures have to be met, and specify the practical or legal impediments to the prompt transfer of own funds and the repayment of liabilities.

The ESAs considered the interaction of the provision concerning the exemption of intragroup OTC derivatives and the recognition of third countries regulatory regimes referred to in Article 13(2) of the EMIR. A special provision is included to avoid a situation where exemption cannot be granted because the determination is still pending. [Since this would lead to a disproportionate implementation of the margin requirements, it is necessary to postpone the introduction of the requirements concerning initial margin to allow competent authorities to provide a response to the groups applying for an exemption.

Phase-in of the requirements

A last article deals with transitional provisions and phase-in requirements. In order to ensure a proportionate implementation, the RTS propose that the requirements will enter into force on 1 September 2016, giving counterparties subject to these requirements time to prepare for the implementation. The initial margin requirements will be phased in over a period of four years. Initially, the requirements will only apply to the largest market participants. Subsequently, after four years, more market participants will become subject to the requirements. Specifically, from 1 September 2016, market participants that have an aggregate month-end average notional amount of non-centrally cleared derivatives exceeding EUR 3 trillion will be subject to the requirements from the outset. From 1 September 2020, any counterparty belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives exceeds EUR 8 billion will be subject to the requirements. Similarly, but with a shorter timescale, the requirements for the

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RISK-MANAGEMENT PROCEDURES FOR NON-CENTRALLY CLEARED OTC DERIVATIVES implementation of variation margin will be binding for the major market participants from September 2016 and for all the other counterparties that fall within the scope of these RTS by 1 March 2017. Therefore, the requirements of these RTS are fully aligned with the BCBS and IOSCO standards, as amended in March 20155.

During the development of the RTS, the issue of the risks posed by physically settled foreign exchange contracts was carefully considered. To maintain international consistency, entities subject to the RTS may agree not to collect initial margin on physically settled foreign exchange forwards and swaps, or the principal in cross-currency swaps. Nevertheless, counterparties are expected to post and collect the variation margin associated with these physically settled contracts, which is assessed to sufficiently cover the risk. It should be noted, however, that in the EU there is currently no unique definition of physically settled FX forwards and introducing this requirement before such a common definition is introduced at Union level would have significant distortive effects. For this reason, the draft RTS introduce a delayed application of the requirement to exchange variation margins for physically settled FX forwards. Given that this inconsistency at EU level is expected to be solved via the Commission delegated act defining theses type of derivatives under MiFID II, the postponement is linked to the earlier of the date of entry into force of this delegated act and 31 December 2018. This is to provide certainty regarding the full application of these RTS should there be delays in the adoption of this delegated act.

Uncertainty about whether or not equity options or options on equity indexes will be subject to margin in other jurisdictions justifies caution in the implementation of the margin requirements within the Union. The final draft RTS include a phase-in of three years for these kinds of options to avoid regulatory arbitrage.

The phase-in requirements give smaller market participants more time to develop the necessary systems and implement the RTS. Moreover, it is important to streamline the implementation of this framework and to align it with international standards in order to achieve a global level playing field.

The approval process for the exemption referred to in Article 11(5) to 11(10) of the EMIR may not be completed by the 1 September 2016. Therefore, Union counterparties belonging to the same group should not be required to collect and post initial margin when dealing among them, even where the exemption process is not complete. The ESA acknowledge the cost that requiring initial margin for intragroup transaction would have, especially considering the fact that those requirements may apply only for a short period of time until when the exemption is granted. However, counterparties belonging to the same group should at least exchange variation margin in accordance with the BCBS-IOSCO framework schedule. This does not require setting aside dedicated financial resources. Furthermore, exchanging variation margin is already common practice among major derivative dealers, which are the ones in the scope of the first phase of the initial margin requirements. For this reason the ESAs introduced a specific deadline for the exchange of initial margins for non-exempted intragroup transactions (1 March 2017), which would allow the relevant authorities to complete the assessment of the relevant requests for exemptions.

5 Margin requirements for non-centrally cleared derivatives, issued by the Basel Committee and IOSCO on March 2015.

13

http://www.bis.org/bcbs/publ/d317.htm


14


3. Draft regulatory technical standards on risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty under Article 11(15) of Regulation (EU) No 648/2012

EUROPEAN COMMISSION

Brussels, XXX [](2015) XXX draft

COMMISSION DELEGATED REGULATION (EU) No /..

of XXX

Supplementing Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories of the European Parliament and of the Council with regard to

regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty

(Text with EEA relevance)

15


EXPLANATORY MEMORANDUM 1. CONTEXT OF THE DELEGATED ACT Article 11(15) of Regulation (EU) No 648/2012 (the Regulation) as amended by Regulation (EU) No 575/2013 (CRR) empowers the Commission to adopt, following submission of draft standards by the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Market Authority, which constitute the European Supervisory Authorities (ESA), and in accordance with either Articles 10 to 14 of Regulation (EU) No 1093/2010, Regulation (EU) No 1094/2010 and Regulation (EU) No 1095/2010 delegated acts specifying the risk-management procedures, including the levels and type of collateral and segregation arrangements, required for compliance with paragraph 3 of Article 11 of the Regulation, the procedures for the counterparties and the relevant competent authorities to be followed when applying exemptions under paragraphs 6 to 10 and the applicable criteria referred to in paragraphs 5 to 10 including in particular what should be considered as practical or legal impediment to the prompt transfer of own funds and repayment of liabilities between the counterparties.

In accordance with Article 10(1) of Regulation (EU) No 1093/2010, Regulation (EU) No 1094/2010 and Regulation (EU) No 1095/2010 establishing the ESA, the Commission shall decide within three months of receipt of the draft standards whether to endorse the drafts submitted. The Commission may also endorse the draft standards in part only, or with amendments, where the Union's interests so require, having regard to the specific procedure laid down in those Articles.

2. CONSULTATIONS PRIOR TO THE ADOPTION OF THE ACT In accordance with the third subparagraph of Article 10(1) of Regulation (EU) No 1093/2010, Regulation (EU) No 1094/2010 and Regulation (EU) No 1095/2010, the ESA have carried out a public consultation on the draft technical standards submitted to the Commission in accordance with Article 11(15) of Regulation (EU) No 648/2012. A discussion paper and two consultation papers were published on the ESA websites respectively on 6 March 2012, 14 April 2014 and 10 June 2015. Together with these draft technical standards, the ESA have submitted an explanation on how the outcome of these consultations has been taken into account in the development of the final draft technical standards submitted to the Commission.

Together with the draft technical standards, and in accordance with the third subparagraph of Article 10(1) of Regulation (EU) No 1093/2010, Regulation (EU) No 1094/2010 or Regulation (EU) No 1095/2010, the ESA have submitted its impact assessment, including its analysis of the costs and benefits, related to the draft technical standards submitted to the Commission. This analysis is available at https://eiopa.europa.eu/Pages/Publications/Draft-Regulatory-Technical-Standards-on-margin-requirements-for-non-centrally.aspx.

3. LEGAL ELEMENTS OF THE DELEGATED ACT This delegated act covers three mandates in the following areas:

a) the risk-management procedures, including the levels and type of collateral and segregation arrangements;

16

https://eiopa.europa.eu/Pages/Publications/Draft-Regulatory-Technical-Standards-on-margin-requirements-for-non-centrally.aspxhttps://eiopa.europa.eu/Pages/Publications/Draft-Regulatory-Technical-Standards-on-margin-requirements-for-non-centrally.aspx


b) the procedures for the counterparties and the relevant competent authorities to be followed when applying exemptions for intragroup OTC derivative contracts;

c) the applicable criteria on what should be considered as practical or legal impediment to the prompt transfer of own funds and repayment of liabilities arising from OTC derivative contracts between the counterparties belonging to the same group.

Therefore, this delegated act is structured in three chapters in line with each of the areas covered by the mandate. Since the first chapter is more complex, it was necessary to split it further in various sections. A final chapter includes transitional and final provisions.

The first chapter covers all the requirements concerning the risk management procedures for the margin exchange, detailed procedures for specific cases, the approaches to be applied for the margin calculation, the procedures around the margin collection, the eligibility, valuation and treatment of collateral, the operational aspects and requirements concerning the trading documentation.

The second chapter includes the procedures for the counterparties and the relevant competent authorities when applying exemptions for intragroup derivative contracts including process, timing and notifications to authorities.

The criteria for applying exemptions for intragroup derivative contracts and what has to be considered a practical or legal impediment are specified in the third chapter. In particular, legal impediments include not only regulatory constraints but also constraints that may arise by internal restrictions or legally binding agreements within and outside the group.

A fourth chapter includes transitional and final provisions. The need for international convergence, regulatory arbitrage and specific characteristic of the OTC derivative market within the Union make necessary a staggered implementation of these requirements in some specific cases such as intragroup transactions, equity options and foreign exchange forwards.

In developing this delegated act, the ESA took into account the Basel Committee-IOSCO margin framework for non-centrally cleared OTC derivatives and the Basel Committee guidelines for managing settlement risk in foreign exchange transactions.

17


COMMISSION DELEGATED REGULATION (EU) /..

of XXX

Supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard

to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty

(Text with EEA relevance)

THE EUROPEAN COMMISSION,

Having regard to the Treaty on the Functioning of the European Union,

Having regard to Regulation (EU) 648/2012 of 4 July 2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories 1 , and in particular the third subparagraph of Article 11(15) thereof,

Whereas:

(1) Counterparties have an obligation to protect themselves against credit exposures to derivatives counterparties by collecting margins. This Regulation lays out the standards for the timely, accurate and appropriately segregated exchange of collateral. These standards apply on a mandatory basis only to the portion of collateral that counterparties are required by this Regulation to collect or post. However, counterparties which agree to collecting or posting collateral beyond the requirements of this Regulation should be able to choose to have such collateral to be covered by these standards or not.

(2) Over-the-counter derivatives (OTC derivative contracts) entered into by clients or indirect clients cleared by a central counterparty (CCP) may be cleared through a clearing member intermediary or through an indirect clearing arrangement. Under the indirect clearing arrangement, the client or the indirect client posts the margins directly to the CCP, or to the party that is between the client or indirect client and the CCP. Indirectly cleared OTC derivative contracts are considered as centrally cleared and are therefore not subject to the risk management procedures set out in this Regulation.

(3) Counterparties subject to the requirements of Article 11(3) of Regulation (EU) 648/2012 should take into account the different risk profiles of non-financial counterparties that are below the clearing threshold referred to in Article 10 of that Regulation when establishing their risk management procedures for OTC derivative contracts with such entities. It is therefore appropriate to allow counterparties to determine whether or not the level of counterparty credit risk posed by a non-financial counterparty that is below that clearing threshold needs to be mitigated through the exchange of collateral. When taking this decision, the counterparty credit risk resulting from the transactions with the non-financial counterparty should be taken into account

1 OJ L 201, 27.7.2012, p.1.

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together with the size and nature of the OTC derivative contracts. Given that non-financial entities established in a third country that would be below the clearing threshold if established in the Union can be assumed to have the same risk profile as non-financial counterparties below the clearing threshold established in the Union, the same approach should be applied to both types of entities in order to prevent regulatory arbitrage.

(4) A CCP may enter into non-centrally cleared OTC derivative contracts in the context of customer position management upon the insolvency of a clearing member. These trades are subject to requirements on the part of the CCP as referred to in point 2 of Annex II of Delegated Regulation (EU) No 153/2013 2 and are reviewed by the competent authorities. These non-centrally cleared OTC derivative contracts are an important component of a robust and efficient risk management processes for a CCP. The additional liquidity needs that those trades could trigger, were they covered by regulatory margin requirements, would fall under the responsibility of the CCP. As this would potentially increase systemic risk, instead of mitigating it, the risk management procedures set out in this Regulation should not apply to such trades.

(5) Counterparties of OTC derivatives contracts need to be protected from the risk of a potential default of the other counterparty. Therefore, two types of collateral in the form of margins are necessary to properly manage the risks to which those counterparties are exposed. The first type is variation margin, which protects counterparties against exposures related to the current market value of their OTC derivative contracts. The second type is initial margin, which protects counterparties against expected losses which could stem from movements in the market value of the derivatives position occurring between the last exchange of variation margin before the default of a counterparty and the time that the OTC derivative contracts are replaced or the corresponding risk is hedged.

(6) Initial margins cover current and potential future exposure due to the default of the other counterparty and variation margins reflect the daily mark-to-market of outstanding contracts. For OTC derivative contracts that imply the payment of a premium upfront to guarantee the performance of the contract, the counterparty receiving the payment of the premium (option seller) is not exposed to current or potential future exposure if the counterparty paying the premium defaults. Also, the daily mark-to-market is already covered by the premium paid. Therefore, where the netting set consists solely of such option positions, the option seller should be able to choose not to collect additional initial or variation margins for these types of OTC derivatives, whereas the option buyer should collect both initial and variation margins as long as the option seller is not exposed to any credit risk.

(7) While dispute resolution processes contained in bilateral agreements between counterparties are useful for minimising the length and frequency of disputes, counterparties should, at a first stage, collect at least the undisputed amount in case the amount of a margin call is disputed. This will mitigate the risk arising from the

2 Commission Delegated Regulation (EU) No 153/2013, of 19 December 2012, supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on requirements for central counterparties (OJ L 52, 23.2.2013, p.41).

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disputed transactions and therefore ensure that OTC derivative contracts are collateralised in accordance with this Regulation. However, both parties should make all necessary and appropriate efforts, including timely initiation of dispute resolution protocols, to resolve the dispute and exchange any required margin in a timely fashion.

(8) In order to guarantee a level playing field across jurisdictions, where a counterparty established in the Union enters into a OTC derivative contract with a counterparty that is established in a third country and would be subject to the requirements of this Regulation if it was established in the Union, initial and variation margins should be exchanged in both directions. Counterparties should remain subject to the obligation of assessing the legal enforceability of the bilateral agreements and the effectiveness of the segregation agreements. When such assessments highlight that the agreements might not be in compliance with this Regulation, counterparties established in the Union should identify alternative processes to post collateral, such as relying on third-party banks or custodians domiciled in jurisdictions where the requirements in this Regulation can be guaranteed.

(9) It is appropriate to allow counterparties to apply a minimum transfer amount when exchanging collateral in order to reduce the operational burden of exchanging limited sums when exposures move only slightly. However, it should be ensured that such minimum transfer amount is used as an operational tool and not with the view to serving as an uncollateralised credit line between counterparties. Therefore, a maximum level should be set out for that minimum transfer amount.

(10) For operational reasons, it might in some cases be more appropriate to have separate minimum transfer amounts for the initial and the variation margin. In those cases it should be possible for counterparties to agree on separate minimum transfer amounts for variation and initial margin with respect to OTC derivative contracts subject to this Regulation. However, the sum of the two separate minimum transfer amounts should not exceed the maximum level of the minimum transfer amount set out in this Regulation. For practical reasons, it should be possible to define the minimum transfer amount in the currency in which margins are normally exchanged, which may not be the Euro. However, recalibration of the minimum transfer amount should be frequent enough to maintain its effectiveness.

(11) The scope of products subject to the proposed margin requirements is not consistent across the Union and other major jurisdictions. Where this Regulation require that only OTC derivative contracts governed by Regulation (EU) No 648/2012 are included in the margin calculations for cross-border netting sets, the two counterparties would have to double the calculations to take into account different definitions or different scope of products of the margin requirements. Furthermore, this would likely increase the risk of disputes. Allowing the use of a broader set of products in cross-border netting sets that includes all the OTC derivative contracts that are subject to regulation in one or the other jurisdiction would facilitate the process of margin collection. This approach is consistent with the systemic risk-reduction goal of this Regulation, since all regulated products will be subject to the margin requirements.

(12) Counterparties may choose to collect initial margins in cash, in which case the collateral should not be subject to any haircut. However, where initial margins are

20


collected in cash in a currency different than the currency in which the contract is expressed, currency mismatch may generate foreign exchange risk. For this reason, a currency mismatch haircut should apply to initial margins collected in cash in another currency. For variation margins collected in cash no haircut is necessary in line with the BCBS-IOSCO framework, even where the payment is executed in a different currency than the currency of the contract.

(13) When setting the level of initial margin requirements, the international standard setting bodies referred to in Recital 24 of Regulation (EU) No 648/2012 have explicitly considered two aspects in their framework. This framework is the Basel Committee on Banking Supervision and Board of the International Organization of Securities Commissions Margin requirements for non-centrally cleared derivatives, March 2015 (BCBS-IOSCO framework). The first aspect is the availability of high credit quality and liquid assets covering the initial margin requirements. The second is the proportionality principle, as smaller financial and non-financial counterparties might be hit in a disproportionate manner from the initial margin requirements. In order to maintain a level playing field, this Regulation should introduce a threshold below which two counterparties are not required to exchange initial margin that is exactly the same as in the BCBS-IOSCO framework. This should substantially alleviate costs and operational burden for smaller participants and address the concern about the availability of high credit quality and liquid assets without undermining the general objectives of Regulation (EU) No 648/2012.

(14) While the thresholds should always be calculated at group level, investment funds should be treated as a special case as they can be managed by a single investment manager and captured as a single group. Where the funds are distinct pools of assets and they are not collateralised, guaranteed or supported by other investment funds or the investment manager itself, they are relatively risk remote from the rest of the group. Such investment funds should therefore be treated as separate entities when calculating the thresholds. This approach is consistent with the BCBS-IOSCO framework.

(15) With regard to initial margin, the requirements of this Regulation will likely have a measurable impact on market liquidity, as assets provided as collateral cannot be liquidated or otherwise reused for the duration of the OTC derivative contract. Such requirements will represent a significant change in market practice and will present certain operational and logistical challenges that will need to be managed as the new requirements come into effect. Taking into account that the variation margin already covers realised fluctuations in the value of OTC derivatives contracts up to the point of default, it is considered proportionate to apply a threshold of EUR 8 billion in gross notional amounts of outstanding OTC derivative contracts to the application of the initial margin requirements under this Regulation. This threshold applies at the group level or, where the counterparty is not part of a group, at the level of the single entity. Further, counterparties that are above this threshold and therefore subject, prima facie, to the initial margin requirements should have the option of not collecting initial margin for an amount of up to EUR 50 million, calculated at group level, and an amount of up to EUR 10 million, calculated at intragroup level. The aggregated gross notional amount of outstanding OTC derivative contracts should be used as the measure given that it is an appropriate benchmark, or at least an acceptable proxy, for

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measuring the size and complexity of a portfolio of non-centrally cleared OTC derivatives. It is also a benchmark that is easy to monitor and report. These thresholds are also in line with the BCBS-IOSCO framework for non-centrally cleared OTC derivatives.

(16) Exposures arising from either OTC derivative contracts or to counterparties that are permanently or temporarily exempted or partially exempted from margins according to this Regulation, should also be included in the calculation of the aggregated gross notional amount. This is due to the fact that all the contracts contribute to the determination of the size and complexity of a counterparty's portfolio. Therefore, non-centrally cleared OTC derivatives such as physically-settled foreign exchange swaps and forwards, cross currency swaps, swaps associated to covered bonds for hedging purposes and derivatives entered into with exempted counterparties or with respect to exempted intragroup transactions are also relevant for determining the size, scale and complexity of the counterparty's portfolio and should therefore also be included in the calculation of the thresholds.

(17) It is appropriate to set out in this Regulation special risk management procedures for certain types of products that show particular risk profiles. The exchange of variation margin without initial margin should, consistently with the BCBS-IOSCO framework, be considered an appropriate exchange of collateral for physically-settled foreign exchange products. Similarly, as cross-currency swaps can be decomposed in a sequence of foreign exchange forwards, only the interest rate component should be covered by initial margin.

(18) The Commission Delegated Act referred to in Article 4(2) of Directive 2014/65/EU introduce a harmonised definition of physically-settled foreign exchange forwards within the Union. At this juncture, these products are defined in a non-homogenous way in the Union. Therefore, in order to avoid creating an un-level playing field within the Union, it is necessary that the corresponding risk mitigation techniques in this Regulation are aligned to the date of entry into force of that Delegated Act. A specific date on which the margin requirements for such products will enter into force even in absence of that Delegated Act is also laid down in this Regulation to avoid excess delays in the introduction of the risk mitigation techniques set out in this Regulation, with respect to the BCBS-IOSCO framework.

(19) In order to ensure a level playing field for Union counterparties on a global level, in order to avoid market fragmentation, and acknowledging the fact that in some jurisdictions the exchange of variation and initial margin for single-stock options and equity index options is not subject to equivalent margin requirements, the treatment of those products should be aligned to international practices. This can be achieved by a delayed implementation of the requirements concerning the margin exchange given there is no international alignment on the margins for those types of options.

(20) Recital 24 of Regulation (EU) No 648/2012 states that this Regulation should take into account the impediments faced by covered bonds issuers or cover pools in providing collateral. Under a specific set of conditions, covered bonds issuers or cover pools should therefore not be required to post collateral. This includes the case where the relevant OTC derivative contracts are only used for hedging purposes and where a regulatory overcollateralization is required. This should allow for some flexibility for

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covered bonds issuers or cover pools while ensuring that the risks for their counterparties are limited.

(21) Covered bond issuers or cover pools may face legal impediments to posting and collecting non-cash collateral for initial or variation margin or posting variation margin in cash. However, there are no constraints on a covered bond issuer or cover pool to return cash previously collected as variation margin. Counterparties of covered bond issuers or cover pools should therefore be required to post variation margin in cash and should have the right to get back part or all of it, but the covered bond issuers or cover pools should only be required to post variation margin for the amount in cash that was previously received. The reason behind this is that a variation margin payment could be considered a claim that ranks senior to the bond holder claims, which could result in a legal impediment. Similarly, the possibility to substitute or withdraw initial margin could be considered a claim that ranks senior to the bond holder claims facing the same type of constraints.

(22) Counterparties should always assess the legal enforceability of their netting and segregation agreements. Where, because of the legal framework of a third country, these assessments turn out to be negative (non-netting jurisdictions), it can happen that counterparties have to rely on arrangements different from the two-way exchange of margins. With a view to ensuring consistency with international standards, to avoid that it becomes impossible for Union counterparties to trade with counterparties in those jurisdictions and to ensure a level playing field for Union counterparties it is appropriate to set out a minimum threshold below which counterparties can trade with those non-netting jurisdictions without exchanging initial or variation margins. Where the counterparties have the possibility to collect margins and it is ensured that for the collected collateral, as opposed to the posted collateral, the provisions of this Regulation can be met, Union counterparties should always be required to collect collateral. Exposures from those contracts that are not covered by any exchange of margin because of the legal impediments in non-netting jurisdictions should be constrained by setting a limit, as capital is not considered equivalent to margin exchange in relation to the exposures arising from OTC derivative contracts. The limit should be set in such a way that it is simple to calculate and verify. To avoid the build-up of systemic risk and to avoid that such specific treatment would create the possibility to circumvent the provisions of this Regulation, the limit should be set at a very low level. These treatments would be considered sufficiently prudent, because there are also other risk mitigation techniques as an alternative to margins. For example, credit institutions usually have to hold capital for cross border OTC derivative contracts with counterparties in non-netting jurisdictions on a gross basis because the netting arrangements are not legally enforceable and therefore not recognised for regulatory purposes.

(23) In case that collateral cannot be liquidated immediately after default, it is necessary to take into account the time period from the most recent exchange of collateral covering a netting set of OTC derivative contracts with a defaulting counterparty until the OTC derivative contracts are closed out and the resulting market risk is re-hedged, which is known as 'margin period of risk' (MPOR) and is the same tool as that used in Article

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272(9) of Regulation (EU) No 575/2013 of the European Parliament and of the Council3. Nevertheless, as the objectives of the two Regulations differ, and Regulation (EU) No 575/2013 sets out rules for calculating the MPOR for the purpose of own funds requirements only, this Regulation should include specific rules on the MPOR that are required in the context of the risk management procedures for non-centrally cleared OTC derivatives. The MPOR should take into account the processes required by this Regulation for the exchange of margins. Normally, both initial and variation margin are exchanged no later than the end of the following business day. An extension of the time for the exchange of variation margin could be compensated by an adequate rescaling of the MPOR. Therefore, taking into account possible operational issues, it should be allowed to extend the time for the exchange of variation margin where such an extension is included in the rescaling of the MPOR. Alternatively, where no initial margin requirements apply an extension is allowed if an appropriate amount of additional variation margin has been collected.

(24) When developing initial margin models and when estimating the appropriate MPOR, counterparties should take into account the need to have models that capture the liquidity of the market, the number of participants in that market and the volume of the relevant OTC derivative contracts. At the same time there is the need to develop a model that both parties can understand, reproduce and on which they can rely to solve disputes. Therefore counterparties should be allowed to calibrate the model and estimate MPOR dependent only on market conditions, without the need to adjust their estimates to the characteristics of specific counterparties. This in turn implies that counterparties may choose to adopt different models to calculate the initial margin, and that the initial margin requirements are not symmetrical.

(25) While there is a need for recalibrating an initial margin model with sufficient frequency, a new calibration might lead to unexpected levels of margin requirements. For this reason, an appropriate time period should be established, during which margins may still be exchanged based on the previous calibration. This should allow counterparties to have enough time to comply with margin calls resulting from the recalibration.

(26) Collateral should be considered as being freely transferable in the case of a default of the collateral provider if there are no regulatory or legal constraints or third party claims, including those of the third party custodian. However, certain claims, such as costs and expenses incurred for the transfer of the collateral, in the form of liens routinely imposed on all securities transfer should not be considered an impediment. Otherwise it would lead to a situation where an impediment would always be identified.

(27) The collecting counterparty should have the operational capability to appropriate and, where necessary, to liquidate the collateral in the case of a default of the collateral provider. The collecting counterparty should also be able to use the cash proceeds of liquidation to enter into an equivalent contract with another counterparty or to hedge

3 Regulation (EU) No 575/2013 of the European Parliament and of the Council of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 (OJ L 176, 27.6.2013, p. 1).

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the resulting risk. Having access to the market should be a pre-requisite for the collateral taker to enable it to either sell the collateral or repo it within a reasonable amount of time. This capability should be independent of the collateral provider and should therefore include having broker arrangements and repo arrangements with other counterparties or comparable measures.

(28) Collateral collected must be of sufficiently high liquidity and credit quality to allow the collecting counterparty to liquidate the positions without significant price changes in case the other counterparty defaults. The credit quality of the collateral should be assessed relying on recognised methodologies such as the ratings of external credit assessment institutions. In order to mitigate the risk of mechanistic reliance on external ratings, however, this Regulation should introduce a number of additional safeguards. These should include the possibility to use an approved Internal Rating Based ('IRB') model and the possibility to delay the replacement of collateral that becomes ineligible due to a rating downgrade, with the view to efficiently mitigating potential cliff effects that may arise from excessive reliance on external credit assessments.

(29) While haircuts mitigate the risk that collected collateral is not sufficient to cover margin needs in a time of financial stress, other risk mitigants are also needed when accepting non-cash collateral. In particular, counterparties should ensure that the collateral collected is reasonably diversified in terms of individual issuers, issuer types and asset classes.

(30) The impact on financial stability of collateral liquidation by non-systemically important counterparties may be expected to be limited. Further, concentration limits on initial margin might be burdensome for counterparties with small OTC derivative portfolios as they might have only a limited range of eligible collateral. Therefore, even though collateral diversification is a valid risk mitigant, non-systemically important counterparties should not be required to diversify collateral. On the other hand, systemically important financial institutions and other counterparties with large OTC derivative portfolios trading with each other should apply the concentration limits at least to initial margin and that should include Member States sovereign debt securities. Those counterparties are sophisticated enough to either transform collateral or to access multiple markets and issuers to sufficiently diversify the collateral posted. Article 131 of Directive 2013/36/EU4 provides for the identification of institutions as systemically important under Union law. However, given the broad scope of Regulation (EU) No 648/2012, a quantitative threshold should be introduced so that the requirements for concentration limits apply also to counterparties that might not fall under the existing classifications of systemically important institutions but which should nonetheless be subject to concentration limits because of the size of their OTC derivative portfolio. Recital (26) of the EMIR suggests that counterparties such as pension scheme arrangement should be subject to the bilateral collateralisation requirements; the same recital, however, recognises the need to avoid excessive burden from such requirements on the retirement income of future pensioners.

4 Directive 2013/36/EU of the European Parliament and of the Council of 26 June 2013 on access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms, amending Directive 2002/87/EC and repealing Directives 2006/48/EC and 2006/49/EC (OJ L 176, 27.6.2013, p. 338).

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Therefore it would be disproportionate to require those counterparties to apply the requirements to monitor the concentration limits in the same manner as for other counterparties. Consequently, it is appropriate to provide that the monitoring of such exposures is carried out on a less frequent basis than for other counterparties, provided that the exposures of such counterparties remain significantly below the level where the concentration limits start applying. For the same reasons, where this condition is only temporarily not met it is appropriate to provide the possibility for those counterparties to return to the monitoring of such exposures on a less frequent basis.

(31) In order to limit the effects of the interconnectedness between financial institutions that may arise from non-centrally cleared derivative contracts, different concentration limits should apply to the different classes of debt securities issued by the financial sector. Therefore, stricter diversification requirements should be set out for debt securities issued by institutions and used as collateral for initial margin purposes. On the one hand, the difficulties in segregating cash collateral should be acknowledged by allowing participants to post a limited amount of initial margin in the form of cash and by allowing custodians to reinvest this cash collateral in accordance with the relevant rules on custody services. On the other hand, cash held by a custodian is a liability that the custodian has towards the posting counterparty, which generates a credit risk for the posting counterparty. Therefore, in order to address the general objective of Regulation (EU) No 648/2012 to reduce systemic risk, the use of cash as initial margin should be subject to diversification requirements at least for systemically important institutions. Systemically important institutions should be required to either limit the amount of cash initial margin collected for the purpose of this Regulation or to diversify the exposures relying in more than one custodian.

(32) The value of collateral should not exhibit a significant correlation with the creditworthiness of the collateral provider or the value of the underlying non-centrally cleared derivatives portfolio, since this would undermine the effectiveness of the protection offered by the collateral collected. Accordingly, securities issued by the collateral provider or its related entities should not be accepted as collateral. Counterparties should be required to monitor that collateral collected is not subject to more general forms of wrong way risk.

(33) It should be possible to liquidate assets collected as collateral for initial or variation margin in a sufficiently short time in order to protect collecting counterparties from losses on non-centrally cleared OTC derivatives contracts in the event of a counterparty default. These assets should therefore be highly liquid and should not be exposed to excessive credit, market or foreign exchange risk. To the extent that the value of the collateral is exposed to these risks, appropriately risk-sensitive haircuts should be applied.

(34) In order to ensure timely transfer of collateral, counterparties should have efficient operational processes in place. This requires that the processes for the bilateral exchange of collateral are sufficiently detailed, transparent and robust. A failure by counterparties to agree upon and provide an operational framework for efficient calculation, notification and finalisation of margin calls can lead to disputes and fails that result in uncollateralised exposures under OTC derivative contracts. As a result, it is essential that counterparties set clear internal policies and standards in respect of

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collateral transfers. Any deviation from those standards should be rigorously reviewed by all relevant internal stakeholders that are required to authorise those deviations. Furthermore, all applicable terms in respect of operational exchange of collateral should be accurately recorded in detail in a robust, prompt and systematic way.

(35) Trading relationship documentation should be produced by counterparties entering into multiple OTC derivative contracts in order to provide legal certainty. As a result, the trading relationship documentation should include all material rights and obligations of the counterparties applicable to non-centrally cleared OTC derivative contracts. Where parties enter into a single, one-off OTC derivative contract, the trading relationship documentation could take the form of a trade confirmation that includes all material rights and obligations of the counterparties.

(36) Collateral protects the collecting counterparty in the event of the default of the posting counterparty. However, both counterparties are also responsible for ensuring that the collateral collected does not increase the risk for the posting counterparty in case the collecting counterparty defaults. For this reason, the bilateral agreement between the counterparties should allow both counterparties to access the collateral in a timely manner when they have the right to do so, hence the need for rules on segregation and for rules providing for an assessment of the effectiveness of the agreement in this respect, taking into account the legal constraints and the market practices of each jurisdiction.

(37) The re-hypothecation, re-pledge or re-use of collateral collected as initial margins would create new risks due to claims of third parties over the assets in the event of a default. Legal and operational complications could delay the return of the collateral in the event of a default of the initial collateral taker or the third party or even make it impossible. In order to preserve the efficiency of the framework and ensure a proper mitigation of counterparty credit risks, the re-hypothecation, re-pledge or re-use of collateral collected as initial margin should therefore not be permitted.

(38) Given the difficulties in segregating cash, the current practices on the exchange of cash collateral in certain jurisdictions and the need of relying on cash instead of securities in certain circumstances where transferring securities may be impeded by operational constraints, cash collateral collected as initial margin should always be held by a central bank or third party credit institution, since this ensures the separation from the two counterparties in the OTC derivative contract. To ensure such separation, the third party credit institution should not belong to the same group as either of the counterparties. Credit institutions that are not able to segregate cash collateral should be allowed to reinvest cash deposited as initial margin.

(39) When a counterparty notifies the relevant competent authority regarding the exemption of intragroup transactions, in order for the competent authority to decide whether the conditions for the exemption are met, the counterparty should provide a complete file including all relevant information.

(40) For a group to be deemed to have adequately sound and robust risk management procedures, a number of conditions have to be met. The group should ensure a regular monitoring of the intragroup exposures. The timely settlement of the obligations resulting from the intragroup OTC derivative contracts should be guaranteed, based

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on the monitoring and liquidity tools at group level, which are consistent with the complexity of the intragroup transactions.

(41) In order to for the exemption for intragroup transactions to be applicable, it must be certain that no legislative, regulatory, administrative or other mandatory provisions of applicable law could legally prevent the intragroup counterparties from meeting their obligations to transfer monies or repay liabilities or securities under the terms of the intragroup transactions. Similarly, there should be no operational or business practices of the intragroup counterparties or the group that could result in funds not being available to meet payment obligations as they fall due on a day-to-day basis, or in prompt electronic transfer of funds not being possible.

(42) This Regulation includes a number of detailed requirements to be met for a group to obtain the exemption from posting margin for intragroup transactions. In addition to those requirements, where one of the two counterparties in the group is domiciled in a third-country for which an equivalence determination under Article 13(2) of Regulation (EU) No 648/2012 has not yet been provided, the group has to exchange, and where appropriate segregate, variation and initial margins for all the intragroup transactions with the subsidiaries in those third-countries. In order to avoid a disproportionate application of the margin requirements and taking into account similar requirements for clearing obligations, this Regulation should provide for a delayed implementation of that particular requirement. This would allow enough time for completing the process to produce the equivalence determination, while not requiring an inefficient allocation of resources to the groups with subsidiaries domiciled in third-countries.

(43) Taking into account the principle of proportionality, counterparties that have smaller portfolios and therefore generally smaller operations should be allowed more time to adapt their internal systems and processes in order to comply with the requirements of this Regulation. In order to achieve a proper balance between mitigating the risks of OTC derivatives and the proportionate application of this Regulation, as well as achieve international consistency and minimise possibilities of regulatory arbitrage with the view to avoiding economic disruptions, a phase-in period of the requirements is necessary. The phase-in period for the requirements introduced in this Regulation are consistent with the schedule agreed in the BCBS-IOSCO framework.

(44) In order to avoid any retroactive effect of this Regulation, the requirements hereunder should apply only to new contracts entered into after the relevant phase-in dates. Exchanges of variation margin and initial margin on contracts entered into before these dates should not be subject to the regulatory obligation to modify the existing bilateral agreements as this would impact their market value.

(45) This Regulation is based on the draft regulatory technical standards submitted by the European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority to the Commission.

(46) The European Banking Authority, the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority have conducted open public consultations on the draft regulatory technical standards on which this Regulation is based, analysed the potential related costs and benefits and requested the

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opinion of the Banking Stakeholder Group established in accordance with Article 37 of Regulation (EU) No 1093/20105, the opinion of the Insurance and Reinsurance Stakeholder Group and the Occupational Pensions Stakeholder Group established in accordance with Article 37 of Regulation (EU) No 1094/20106, and the Securities and Markets Stakeholder Group established in accordance with Article 37 of Regulation (EU) No 1095/20107,

HAS ADOPTED THIS REGULATION:

CHAPTER I Counterparties Risk Management Procedures required for

compliance with paragraph 3 of Article 11 of Regulation (EU) No 648/2012

SECTION 1 RISK MANAGEMENT PROCEDURES

Article 1 General requirements

1. The risk management procedures required for compliance with Article 11(3) of Regulation (EU) No 648/2012 (the risk management procedures) shall apply to financial counterparties within the meaning of Article 2(8) of Regulation (EU) No 648/20

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